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transcript
Irrational Exuberance in Energy Markets:Causes and Consequences
Philip K. Verleger, Jr.
Boulder, CO
April 28, 2016
2
Does This Sound Familiar?
The dimensions of the collapse in the ____ industry during the past
two years have been staggering. Half a million people have lost
their jobs. In that time, the Dow Jones ____ index has dropped 86
percent; the ____ index, 89 percent. These are declines in value
worthy of comparison to the great crash of 1929. Out of the $7
trillion decline in the stock market since its peak, about $2 trillion
have disappeared in the capitalization of ____ companies. Twenty-
three ____ companies have gone bankrupt.
3
The First Mention
…how do we know when irrational exuberance has unduly
escalated asset values, which then become subject to unexpected
and prolonged contractions as they have in Japan over the past
decade?
Federal Reserve Chairman Alan Greenspan, “The Challenge of Central Banking in a Democratic Society,”
remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public
Policy Research, Washington, DC, December 5, 1996.
4
Oil Price Collapse: Third Episodeof IE in the Twenty-First Century
Episode 1: The Dotcom Meltdown
Episode 2: The Housing Price Bubble
Episode 3: The Oil Price Bubble
5
The Oil Bubble Is the Smallest:So Far
The dimensions of the collapse in the telecommunications industry
during the past two years have been staggering. Half a million
people have lost their jobs. In that time, the Dow Jones
communications technology index has dropped 86 percent; the
wireless communications index, 89 percent. These are declines in
value worthy of comparison to the great crash of 1929. Out of the
$7 trillion decline in the stock market since its peak, about $2 trillion
have disappeared in the capitalization of telecom companies.
Twenty-three telecom companies have gone bankrupt.
Paul Starr, “The Great Telecom Implosion,” The
American Prospect, September 8, 2002
6
The Consequence of the Dotcom Bubble
And the storm is not over. Many other firms, including some of the
biggest, are teetering under a heavy load of debt. Altogether, the
industry owes a trillion dollars, “much of which will never be repaid
and will have to be written off by investors.”
Paul Starr quoting Senate testimony of FCC Chairman
Michael Powell, July 30, 2002.
7
“Irrational Exuberance”: The Definition
A situation in which news of price increases spurs investor
enthusiasm, which spreads by psychological contagion from person
to person, in the process amplifying stories that might justify the
price increase and bringing in a large and larger class of investors,
who, despite doubts about the real value of an investment, are
drawn to it partly through envy of others’ success and partly through
a gambler’s excitement.
Robert J. Shiller, Irrational Exuberance (Third Edition,
2016), p. 240.
8
The Shiller Graph:Share Prices vs. Earnings, 1871 to 2016
0
500
1000
1500
2000
2500
1871 1891 1911 1931 1951 1971 1991 2011
Re
al
S&
P C
om
po
sit
e I
nd
ex
0
50
100
150
200
250
300
350
400
450
500
Re
al S
&P
Co
mp
os
ite
Ea
rnin
gs
Share Prices Earnings
Source: Irrrationalexuberance.com.
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Consequences of Irrational Exuberance
Excess investment in capacity
Low prices for future output
Unwillingness of lenders to advance credit for future
growth
Bankruptcy for traditional providers failing to adjust
10
Telecommunications Illustrates Consequences of Irrational Exuberance
Invention of cell phone and introduction of Internet
created enormous demand for band width.
Massive construction of fiber-optic systems followed.
Much of the fiber-optic system remained dark for
years and is still dark.
However, the availability of networks drove down
communications costs. Bankrupt firms wrote off
investment costs and offered low prices.
Costs of communicating by cell phones fell.
Landline phone companies went bankrupt.
11
Price Index of Cellular Communications vs.Landline (LL) Communications, 1985 to 2015
0
50
100
150
200
250
1985 1990 1995 2000 2005 2010 2015
Ind
ex
Cellular LL Local LL Long Distance
Source: US Bureau of Economic Analysis.
12
Share of Consumer Dollars Allocated toThree Types of Telephone Communications
0
10
20
30
40
50
60
70
80
1985 1990 1995 2000 2005 2010 2015
Perc
en
t
Cellular LL Local LL Long Distance
Source: US Bureau of Economic Analysis.
13
“Ownership Society Boom”Offers Similar Results
The United States benefited from very large financial
flows from China resulting from the trade deficit. The
funds went to banks for lending.
Interest rates fell.
The housing sector was the beneficiary.
– Mortgage rates were cut.
– New home buyers were attracted.
Housing prices surged.
Housing construction surged.
Housing ownership costs rose.
14
Housing Price Irrationality:Case-Shiller Housing Price Index, 1987 to 2015
0
50
100
150
200
250
1987 1991 1995 1999 2003 2007 2011 2015
Ind
ex
(J
an
ua
ry 2
00
0 =
10
0)
20-City Composite San Francisco Detroit
Source: McGraw Hill Financial.
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0.80
0.85
0.90
0.95
1.00
1.05
1985 1990 1995 2000 2005 2010 2015
Re
lati
ve
Ho
us
ing
Pri
ce
0.0
0.5
1.0
1.5
2.0
2.5
Ho
us
ing
Sta
rts
(Mil
lio
ns
at
An
nu
al
Ra
tes
)
Housing Price Housing Starts
Impact on Housing Costs: Cost of Housingvs. Total Housing Starts, 1985 to 2015
Source: US Bureau of Economic Analysis; US Census Bureau.
16
Factors Causing Irrational Exuberance
Changes in government regulation
Projections
Easy availability of credit
Government incentives
Myopia
Regulatory failures
17
Bubbles Can Sometimes BeAvoided or Popped Early
The housing bubble could have been avoided by prudent regulation.
– The Office of Federal Housing Enterprise Oversight (OFHEO) had been created to prevent future housing bubbles following the 1980 experience. Its officials saw nothing in the rise in prices or mortgage practices to warrant action.
– Federal Reserve officials did not believe housing prices could plunge as they did.
International energy officials missed an opportunity to hold prices around $80 per barrel when production in Libya collapsed.
– Strategic stocks were more than adequate.
– However, many policymakers did not want to intervene in markets.
– Furthermore, high prices were seen as a spur to investment.
18
Major Factors Contributingto the Three Bubbles
Dotcom Housing Petroleum
Change in Government
Regulations
Deregulation of
communications
Mortgage rules on
banks
Low-sulfur
diesel in Europe
Projections Rapid growth Need for housing Peak oil
Easy Credit Banks and
bonds
China cash Banks and
bonds
Government Incentives ??? Demands to lend
to low income
IEA calls for
industry
investment
Myopia Yes Yes Yes
Regulatory Failure None No oversight Failure to use
strategic stocks
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Irrational Exuberance in Energy Fanned by Regulatory Changes at the Right Time
Bubble caused by irrational exuberance required several elements: optimism, fuel, and myopia.
The energy bubble was fueled by fears of running out.
– The End of Oil (Paul Roberts)
– Twilight in the Desert (Matthew Simmons)
– Fiction published by IEA in various World Energy Outlooks
The EU poured fuel on the fire with a badly timed shift to ultra-low-sulfur diesel.
– Refiners required light sweet crude to make the product.
– A shortage of light sweet crude in 2008 sent crude prices to record levels.
Industry myopia led to excessive investments.
– Pessimists do not build fiber-optic networks, construct large housing developments, or explore for oil.
– Oil industry officials, mostly engineers, by nature believe that prices can only go up.
20
June Refining Margins for Distillate in Rotterdam Illustrate Regulatory Effect
-20
0
20
40
60
80
100
120
140
160
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008Marg
in (
Sp
ot
Gaso
il l
ess B
ren
t; $
/bb
l)
Source: PKVerleger LLC.
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“One hundred dollars per barrel is becoming
the new $20 in our business.”
John Watson, Chevron CEO, March 2014
22
Episodes of Irrational Exuberance Often, But Not Always, End the Same Way
The 18th century railroad boom after the Civil War
ended when railroads could not pay bondholders.
The dotcom bubble ended when the companies that
had laid the fiber-optics also could not cover their
debt.
The housing bubble ended when consumers could
not meet their mortgage obligations.
The US savings and loan industry, however,
collapsed from deregulation and the end of inflation.
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Excess Investment Leads to Excess Capacity and the Inability to Cover Debt
Again, too many miles of railroad were built in the
absence of regulation.
Too many miles of fiber-optic cable were laid.
In the case of housing, too much money was made
available to buyers.
24
Technical Change Can Fuel Irrational Exuberance
Disruptive technologies that occur simultaneously with financial
bubbles are a lethal economic combination.
Disruptive technologies are inferior production processes that
accomplish the same task for a much lower cost.
– The 3.5-inch “floppy” disk was disruptive. It was not as good
as standard disk drives but it was good enough.
– The personal computer was inferior to the mainframe, but it,
too, was good enough.
Disruptive technologies can destroy industries and firms by
making existing technologies obsolete and preventing recovery
of investment.
25
Fracking and Futures Markets Have Exacerbated the Energy Price Cycle
Fracking is inferior to drilling in deep water, but it,
too, is good enough to access billions of barrels that
were not counted as reserves.
Fracking can be undertaken by very small firms.
Offshore E&P requires very large firms.
26
Fracking Has Destroyedthe Peak Oil Theory
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US Natural Gas Prices Providea Preview of Things to Come
Fracking was first applied to develop US natural gas reserves
in Texas and then in the Marcellus Shale.
Increased supplies drove prices lower and lower.
Rigs were withdrawn and drilling was reduced. The pundits
predicted a quick price recovery. On May 19, 2012, Financial
Times published an article titled “US Natural Gas Prices Set to
Double by 2016, Says Shell.”
– The company used a $4 to $6 per million Btu price for 2015.
– Low prices were predicted to boost demand.
– Others predicted lower supply.
28
Weekly Henry Hub Spot Price forUS Natural Gas, 2000 to 2016
0
2
4
6
8
10
12
14
16
2000 2002 2004 2006 2008 2010 2012 2014 2016
Do
llars
per
mm
Btu
Source: NYMEX.
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New Financial Institutions Promote Competition, Cap Price Increases
Futures markets have always been understood to flatten and lower supply curves.
– Entry by smaller firms is promoted.
– Efficient smaller firms are able to compete with larger, naturally more bureaucratic large companies.
– Counterparties interested in financial returns are attracted.
Futures markets accelerate the forces of “relentless commoditization.”
Investment banks contributed to the process by creating commodity-linked instruments that attracted billions from passive investors.
30
Total Open Interest in Three Principal Crude Oil FuturesContracts, Weekly Data, January 1991 to March 2016
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1991 1994 1997 2000 2003 2006 2009 2012 2015
Th
ou
sa
nd
Co
ntr
ac
ts o
f 1
,00
0 B
arr
els
Source: PKVerleger LLC.
31
Notional Value of Net Long Position of Investors in Commodity Futures, 2008 to 2015
0
50
100
150
200
250
300
Mar-08 Jul-10 May-11 Mar-12 Jan-13 Nov-13 Sep-14 Jul-15
Bil
lio
n D
oll
ars
Source: Commodity Futures Trading Commission.
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The Oil Price Bubble’s CollapseHas Several Causes
The threat of global warming
The end of regulation
Technical change
Increased competition
33
Pressure to Limit Greenhouse Gas Emissions Is theType of Regulatory Change that Makes or Ends Bubbles
Hotelling’s theory has dominated oil industry thinking for decades.
The late Saudi king Abdullah instructed his oil ministry to save oil for future generations in April 2008.
“Oil in the ground is worth more than money in the bank” has instructed oil ministers since oil-exporting countries took charge of their oil forty years ago.
Today, however, oil producers face the fact that a lot of oil may never be produced.
The new advice to oil ministers is “produce your oil before it is too late.”
Ali Naimi said as much in December 2014.
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“There are many things happening in the energy sphere – technology
on the one hand and efficient [sic] on the other, there are politics.
All of these are good for humanity, but they will definitely be a threat
to oil demand in the future. My question to the panel – is there a
black swan that we don’t know about which will come by 2050 and
we will have no demand?”
Ali Naimi. Saudi Arabia’s Oil Minister,
December 2014
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Threat of Global Warming Limits and Increased Competition Led to a Change in Regulation
Key OPEC producers concluded in 2014 that low-cost
producers should no longer subsidize high-cost producers.
Long-term profits may be maximized by producing at maximum
rates for four to ten years.
– Development of high-cost resources such as Australian
LNG, Venezuelan crude, and Canadian heavy crude could
be stopped.
– Penetration of renewables could be slowed.
National interests of producing countries would no longer be
sacrificed to ungrateful high-cost producers.
36
Technical Change May Keepthe Price Bubble from Returning
Technical change is occurring on the demand and supply sides.
Growth in global demand will be depressed by new technologies and fuel substitution.
– Electric vehicles may have reached a tipping point (EIG).
– Natural gas has become a significant threat in the transportation sector.
– Low economic growth, particularly in developing nations, will slow growth of oil use and give alternatives a chance.
Productivity in exploration and production is driving down costs.
– Fracking is a truly disruptive technology.
– The history of disruptive technologies is that costs keep falling. That seems to be the case with fracking.
37
Increased Competition WillIntensify Price Pressure
The oil industry historically has been characterized by monopolistic competition. The interests of oil-producing countries coincided with the interests of the large oil companies.
– Multinational oil firms had no interest in rocking the boat.
– High prices were in everyone’s interest in the upstream industry.
But the oil and natural gas industries are deintegrated. Mid and downstream firms have no interest in sustaining upstream monopolists.
Independent crude oil producers are proliferating, achieving cost reductions, and boosting supply.
It may well be game/set/match for Big Oil and high-cost oil-exporting nations.
38
US Residential Construction Investment vs.Oil and Gas Drilling Investment, 1986 to 2016*
0
100
200
300
400
500
600
700
800
900
1986 1990 1994 1998 2002 2006 2010 2014 2018 2022
Bil
lio
ns
of
Cu
rre
nt
Do
lla
rs
Drilling Housing Investment Nine Years Earlier
IEA Drilling Target Likely Drilling Trend
* Housing expenditures shifted forward eight years.
Source: US Bureau of Economic Analysis; Barclays; PKVerleger LLC.
Marked Behavior Will Be Very Different
There will be little surplus capacity because it is not
in the economic interest of low-cost producers to
hold surplus capacity.
Investment in high-cost projects will be well below
the levels seen as needed by “experts.”
Prices will thus be very volatile.
– Low when there is surplus capacity
– High when there is no surplus capacity
Oil is the new corn.
39
Price Volatility May Accelerate Penetration of Renewables
The large oil companies want steady, high oil prices
for capital-intensive projects. They will not get them.
High, stable prices seem an ideal way to push oil
into oblivion quickly. The large Middle Eastern
countries will not let this happen.
The consequence: Very volatile oil prices will
complicate renewables’ penetration—but may attract
consumers, especially since renewables offer stable
prices.
40
The Futures Market Will Bethe Clear Winner
Those following oil operated on the absurd theory that Saudi
Arabia was the “central bank of oil.” They expected the
Kingdom to adjust output to stabilize prices, sacrificing income.
Those promoting the idea did not understand the role of central
banks.
Futures markets provide a means by which firms in the oil
business can stabilize prices, making a central bank
unnecessary.
Markets will expand further as the liquidity of futures markets
increases.
41
Oil Prices, 1861 to 2015 andPossible Trend to 2030
0
20
40
60
80
100
120
140
160
180
200
1861 1881 1901 1921 1941 1961 1981 2001 2021
Price Trend Projection
42 Source: BP; PKVerleger LLC.
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